Chapter 4: Activity-Based Costing

This chapter is an introduction to functional-based cost systems and activity-based cost

systems. It discusses how costs are assigned to products in the systems and why
activity-based costing may provide better product costs than a traditional, functionalbased cost system.
When we complete this chapter, you should be able to:
1. calculate product costs using a functional-based cost system where manufacturing
overhead is applied using a volume-related measure.
2. assign manufacturing overhead costs to products using a plant-wide overhead rate
and departmental overhead rates.
3. calculate over or underapplied overhead and be able to dispose of it at the end of
the accounting period.
4. discuss the limitations of functional-based costing when there are non-unit related
overhead costs and when product diversity exists.
5. identify the basic elements in the activity-based costing model.
6. explain how primary and secondary activities differ.
7. identify and define unit-level, batch-level, product-level, and facility-level drivers.
8. calculate the cost of products using an activity-based costing system.
9. calculate activity costs and cost of products using a time-driven ABC system.
10. calculate the cost of unused capacity using time-driven ABC rates.
Functional-based cost systems have traditionally been used to determine product costs.
These systems assign only manufacturing costs to products. The three types of
products costs are direct materials, direct labor, and manufacturing overhead.
The functional-based cost model is:
Resources
Support
Departments

Production
Departments

Marketing and
Administrative costs

Product costs

Period costs

With this model, direct materials and direct labor are traced directly to products and
manufacturing overhead is allocated using a volume-related measure such as directlabor hours, direct-labor dollars, or machine hours.
Normal Functional-based cost system:
Most functional-based cost systems are normal cost systems rather than actual cost
systems.
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A normal cost system is one where actual direct materials and actual direct labor are
traced to products, but manufacturing overhead is assigned using a predetermined
overhead rate.
Predetermined =
Overhead rate

Expected (budgeted) manufacturing overhead for the year

Normal activity for the year

Why is expected or budgeted overhead used? Budgeted overhead is used because the
actual overhead for the year will not be known until the year is over. A predetermined
rate based on budgeted data allows the company to determine the cost of products
throughout the year.
Example: A company uses a predetermined plant wide overhead rate based on directlabor hours to apply overhead to products. At the beginning of the year, the company
estimated that it would incur $268,000 of overhead and 10,000 direct-labor hours during
the year.
Predetermined overhead rate =
Example of Functional-based Product Costing:
A company manufactures two products that are called Standard and Custom. Data for
the two products for the year are:
Units
Direct-labor hours
Direct materials
Direct labor

Standard
10,000
5,400
$200,000
$ 54,000

Custom
4,000
4,600
$64,000
$46,000

Determine the costs of the two products when the predetermined plant-wide overhead
rate is used.
Standard
Custom

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Departmental Overhead Rates:

Assume an analysis of the two departments shows the following direct-labor hours,
machine hours, and overhead costs:
Direct-labor hours
Machine hours
Departmental overhead

Cutting Dept.
6,000
11,000
$165,000

Assembly Dept.
4,000
1,000
$103,000

If the Cutting Department is machine intensive and the Assembly Department is labor
intensive, a departmental rate based on machine hours would be appropriate for the
Cutting Department, and a departmental rate based on direct-labor hours would be
appropriate for the Assembly Department.
Cutting Dept. Overhead Rate =
Assembly Dept. Overhead Rate =
To allocate overhead using these departmental rates, the usage of hours in each
department by the two products must be determined. Assume the records show the
following:
Cutting Department:
Direct-labor hours
Machine hours
Assembly Department:
Direct-labor hours
Machine hours

Standard

Custom

3,900
5,000

2,100
6,000

1,500
200

2,500
800

Product costs are calculated as follows:

Direct materials
Direct labor
Overhead:
Cutting Dept.

Standard
$200,000
54,000

Custom
$64,000
46,000

_
10,000

_
4,000

Assembly Dept.
Total
No. of units
Cost per unit

Chapter 4, Page 3

Overapplied and Underapplied Overhead

With a normal cost system, the actual overhead for a period and the applied overhead
for a period are likely to be different. When financial statement are prepared, the
difference must be considered.
Assume the actual manufacturing overhead for the period was $280,000 and the
applied manufacturing overhead was $268,000. The Overhead Control account will
show the following:
Overhead Control
Actual

280,000

Applied

_
268,000

Is overhead over or underapplied?

Treatment of difference if the amount is immaterial:
If the over or underapplied overhead is immaterial (insignificant), it is written off to cost
of goods sold because most of the product costs should be in cost of goods sold at the
end of the year.
A journal entry to record the write-off to cost of goods sold is:
Treatment of difference if the amount is material:
When over or underapplied overhead is material, it is prorated to the accounts that have
balances based on normal costs to restate the balances to approximate actual costs.
Which accounts have balances based on normal costs?

Why is proration required?

Proration is needed because GAAP requires that actual costs be shown for inventories
and cost of goods sold on financial statements. Because of this requirement, if there is
a material difference between actual and normal costs, the normal costs are restated to
approximate actual costs.

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How is the proration calculated?

The proration should be based on the applied manufacturing overhead cost that is
included in the account balance at the end of the year.
Assume the account balances at the end of the period have been analyzed to determine
the applied overhead in each account balance.
Account
Work in Process Inventory
Finished Goods Inventory
Cost of Goods Sold
Total

Applied Overhead in Account

Balance at End of Year
$ 13,400
53,600
201,000
$268,000

If this amount is material (i.e. significant), the proration is as follows:

Applied overhead in
Underapplied
Account
Account Balance Percentage
Overhead
Work in Process Inventory

$ 13,400

Finished Goods Inventory

53,600

Cost of Goods Sold

Total

Prorated
Amount

201,000
$268,000

Journal entry to record proration:

Limitations of functional-based costing systems:

The ability of functional-based costing systems to provide relevant products costs is
limited when there are overhead costs that are not caused by volume and when product
diversity exists.
Non-volume related costs are caused by factors other than volume, i.e. batches,
number of product lines, or capacity.
Product diversity refers to situations where products consume different overhead
resources in different ratios.
When there are non-volume related costs and/or product diversity, traditional volumebased costing tends to overstate the cost of high volume products and understate the
cost of low volume products.
Chapter 4, Page 5

Activity-Based Costing (ABC) Model:

Resources
Costs are assigned using direct
tracing and resource driver tracing
Activities
Costs are assigned using activity
drivers
Cost objects, i.e. products
Basic premise of ABC is that activities consume resources and cost objects (e.g.
products) consume activities.
Definitions:
Resource: An economic element used in the performance of activities.
-materials, labor, supplies
Resource driver: A measure of the quantity of a resource consumed by an activity.
-the percentage of time an employee spends doing various activities.
Activity: Work performed by the organization.
Manufacture products, purchase materials, inspect products
Activity driver: A measure of the frequency and intensity of the demands placed on
activities by cost objects.
-This is the basis for assigning the cost of the activity to cost objects.
Cost object: Any product, customer, service, contract, project, or other unit for which a
separate cost measurement is desired.
Classification of Activities:
1. Primary vs. secondary activities
Primary activities: Activities that are consumed by final cost objects such as a product
or customer.
-manufacturing products, manufacturing activities, delivery activities.
Secondary activities: Activities that are consumed by intermediate cost objects such as
primary activities or other secondary activities.
-An example is supervision.
Chapter 4, Page 6

2. Unit level, Batch level, Product level, and Facility level Activities
Unit-level activities: Activities performed each time a unit is produced.
-manufacturing a products, drilling a hole for a bolt.
Batch-level activities: Activities performed each time a group (batch) of products is
produced.
-setting up production lines for a product.
Product-level activities: Activities performed that enable the various products to be
produced.
-product development, product engineering.
Facility-level activities: Activities that sustain a factorys general manufacturing
processes.

Product costing with Activity-Based Costing:

Assume the $268,000 of overhead costs in our example is related to six activities.
Those cost of each activity and the activity drivers for each activity are:
Activity
Purchasing materials
Receiving
Inspecting
Setting up equipment
Machining
Providing facilities

Driver
No. of purchase orders
No. of deliveries
No. of inspections
No. of setups
Machine hours
Machine hours

Costs
$ 60,000
54,000
52,000
24,000
42,000
36,000
$268,000

The units of the activity driver relating to each product are:

Activity
No. of purchase orders
No. of deliveries
No. of inspections
No. of setups
Machine hours

Standard
600
700
400
125
5,200

Custom
1,000
800
1,200
475
6,800

Total
1,600
1,500
1,600
600
12,000

Using these activity units a rate per driver unit can be calculated by dividing the cost of
each activity by the total units of the activity driver:

Chapter 4, Page 7

Rate per Driver Unit

Purchasing materials

60000/1600=37.50

Receiving

54000/1500=36.00

Inspecting

$52,000 1,600 =

$32.50 per inspection

$24,000 600 =

$40 per setup

Machining

$42,000 12,000 =

$3.50 per machine hr.

Providing facilities

$36,000 12,000 =

$3.00 per machine hr.

Setting up equipment

With these rates the ABC costs are:

Direct materials
Direct labor
Overhead:
Purchasing materials

Standard
$200,000
54,000

Custom
$64,000
46,000

Receiving
Inspecting
Setting up equipment

$32.50 x 400 = 13,000 $32.50 x 1,200 = 39,000

5,000

$40 x 475 = 19,000

Machining

$3.50 x 5,200 = 18,200

$3.50 x 6,800 = 23,800

Providing facilities

$3.00 x 5,200 = 15,600

$3.00 x 6,800 = 20,400

Total

Units

10,000

4,000

Cost per unit

$40 x 125 =

These unit costs differ from the unit costs calculated using a plant-wide overhead rate
and using departmental overhead rates. A comparison of the costs is:

Chapter 4, Page 8

Standard
$39.87

Custom
$59.32

Departmental overhead rates

$36.76

$66.09

ABC rates

$35.35

$69.63

Plant-wide overhead rate

These costs are different because some costs are driven by non-unit level drivers and
because product diversity exists. To evaluate if product diversity exists, consumption
ratios for each activity can be calculated. A consumption ratio is simply the portion of
the total activity that is consumed by a specific product.
For these products, the consumption ratios for each activity are:
Standard
0.375
0.467
0.250
0.208
0.433
0.433

Purchasing material
Receiving
Inspecting
Setting up equipment
Machining
Providing facilities

Custom
0.625
0.533
0.750
0.792
0.567
0.567

Since these consumption ratios differ for the various activities, product diversity exists.
When product diversity exists, activity-based costing will provide better cost data than
traditional costing methods.
Consumption ratios, rather than ABC rates, can be used to assign costs to products. If
consumption ratios are used for the example, the overhead assigned to each product is:
Standard

Custom

0.250 x $52,000 = 13,000

0.750 x $52,000 = 39,000

Purchasing materials
Receiving
Inspecting

Setting up equipment 0.208 x $24,000 =

4,992 0.792 x $24,000 = 19,008

Machining

0.433 x $42,000 = 18,186 0.567 x $42,000 = 23,814

Providing facilities

0.433 x $36,000 = 15,588

Total (some ratios are rounded)

Overhead assigned using ABC rates

0.567 x $36,000 = 20,412

$ 99,484

$168,516

$99,500

$168,500

Chapter 4, Page 9

A problem with ABC systems is that they can be expensive to maintain if many activities
are used for cost assignment. To reduce the cost of maintaining an ABC system,
companies may try to use fewer activities for the cost assignment, or they may use time
estimates to determine the cost of activities.
Two examples of how a company may reduce the number of activities are illustrated in
the textbook on pages 168-174. In the first example, the expensive activities are used
as the basis for assigning all costs. The costs of less expensive activities are added to
the cost of the expensive activities before the cost is assigned.
In the second example, consumption ratios are used to reduce the number of cost
pools. We are not going to work an example of this, but the Cornerstone example 4-9
on pages 172-173 illustrates the method if you are interested in learning more about it.
Time Driven ABC Systems
Time driven ABC systems are another way of reducing the amount of time required for
maintaining an ABC system. Time driven ABC systems are based on estimating the
capacity cost rate and estimating the time required for each activity.
To illustrate time driven ABC systems, assume there are four (4) employees who split up
their time among the purchasing materials, the receiving, and the inspecting activities.
If each employee works 2,000 hours a year, the capacity of the employees is 8,000
hours a year. However, employees are unlikely to function at this capacity. Employees
will need to take breaks, have sick days, undergo training, etc., and these activities will
reduce the time available for purchasing, receiving and inspecting activities. Practical
capacity allows for these types of downtime and might be set at 80 to 90 percent of total
(e.g. theoretical) capacity. If practical capacity is 80 percent of theoretical capacity, the
practical capacity is 0.80 x 8,000 = 6,400 hours.
With time driven ABC, practical capacity is often used to determine the estimated
capacity cost rate. If the four employees cost the company $166,000 annually, then the
estimated cost per unit of resource capacity is:
Estimated capacity cost rate= Cost of resources supplied/practical capacity
Estimated capacity cost rate= $166,000/6,400 hours = $25.9375
To determine the cost of a unit of activity, the time to perform one unit is estimated.
Assume the following times are estimated for the activities:
Purchasing
Receiving
Inspecting

1.4 hours per purchase order

1.0 hours per deliveries
1.2 hours per inspection

Chapter 4, Page 10

These time estimates and the capacity cost rate are then used to calculate the activity
rate for each activity:
Purchasing materials
Receiving
Inspecting
With time driven ABC, some actual costs may not be allocated to the products. These
are unused capacity cost.
Calculation of the cost of used capacity for the three activities:
Activity
Quantity

Rate

Total cost
Assigned

Purchasing materials

1,600

$36.31

$ 58,096

Receiving

1,500

$25.94

38,910

Inspecting

1,600

$31.12

49,792

Activity

Total assigned

$146,798

The total assigned using time-driven ABC is a measure of the capacity used. The
unused capacity is the difference between the capacity supplied and the capacity used:
Total cost of capacity supplied
Total assigned to products
Cost of unused capacity

$166,000
146,798
$ 19,202

Managers can use this measure of unused capacity to help them understand the
companys cost structure and how costs might be reduced.
Time Equations
Sometimes the time required for an activity differs for different products. For example,
assume it takes 0.8 of an hour to perform an inspection of the standard product, but it
takes an additional 0.5 of an hour for an inspection of the custom product Rather than
assigning inspection costs based on number of inspections, it would be better to assign
Chapter 4, Page 11

inspection costs based on duration, ie. time for an inspection. In a time-driven ABC
system, a different rate can be calculated for inspections of the different products. A
time equation for inspection would be:
Inspection time = 0.8 + 0.5 if custom product
The time-driver ABC rate is $25.9375 per hour. Using this rate, the cost of an inspection
for each product would be:
Standard product: 0.8 x $25.9375 = $20.75 per inspection
Custom product (0.8 + 0.5)$25.9375 = 1.3 x $25.8375 = $33.72.

Chapter 4, Page 12